The Risk Of 'Hot' Inflation

Ideological deflationists and inflationists alike find themselves both facing the same problem. The former still carry the torch for a vicious deflationary juggernaut sure to overpower the actions of the mightiest central banks on the planet. The latter keep expecting not merely a strong inflation but a breakout of hyperinflation.

Neither has occurred, and the question is, why not?

The answer is a 'cold' inflation, marked by a steady loss of purchasing power that has progressed through Western economies, not merely over the past few years but over the past decade. Moreover, perhaps it’s also the case that complacency in the face of empirical data (heavily-manipulated, many would argue), support has grown up around ongoing “benign” inflation.

If so, Western economies face an unpriced risk now, not from spiraling deflation, nor hyperinflation, but rather from the breakout of a (merely) strong inflation.

Surely, this is an outcome that sovereign bond markets and stock markets are completely unprepared for. Indeed, by continually framing the inflation vs. deflation debate in extreme terms, market participants have created a blind spot: the risk of a conventional, but 'hot,' inflation.

The Fears of 2008

In the spring of 2008, on the back of the Fed’s easing program that began the previous summer, many global commodities were running to all-time highs. Agricultural commodities were in the headlines, and the high price of corn had caused riots in Mexico the year before. In many respects, the 2007-2008 period prefigured some of the food price pressures that would help drive the Arab Spring three years later, in 2011. Of course, the bulk of the headlines went to the master commodity, oil, which flirted with $90 twice before breaking above the $100 barrier.

Market sentiment understandably turned to inflation. Indeed, during a few Fed meetings, Jeffrey Lacker of the Richmond Fed actually called for rate hikes. And the yield on the 10-year Treasury, which declined into a low of 3.88% towards the end of March 2008, actually rose again to 4.32% over three months into the end of Q2, 2008. The Economist magazine, always ready to provide the cover story, produced a rather memorable offering to the inflation angst that spring.

“Ronald Reagan once described inflation as being “as violent as a mugger, as frightening as an armed robber and as deadly as a hit-man.” Until recently, central bankers thought that this thug had been locked up for life. Thanks to sound monetary policies, inflation worldwide had stayed low in recent years. But the mugger is back on the prowl.”

Here is the cover graphic:

Of course, we know how this particular story ended in 2008: badly. But not in the cloud of inflationary dust that the Economist magazine and hawkish members of the Fed envisioned. No, it ended “badly” with the most severe unleashing of asset deflation the United States had seen since the Great Depression, along with trillions of fresh credit dollars provided by the Federal Reserve needed just to stabilize the system during the long aftershock.

And the Deflationists Still Hold Some Cards

Four years later, the deflationists are still holding a few cards. True, actual recorded deflation was very brief and lasted only 6-9 months immediately after the crisis. And the deflationary spiral many predicted never did occur. Meanwhile, since 2008/2009, poor wage growth in the OECD and the continued supply of cheap labor from the developing world have ensured that one of the classic starter formulas for 'traditional' inflation -- tight labor markets and rising wages -- has failed to ignite.

Probably no market better expresses the ongoing, structural headwind to developed market inflation than the busted housing market. US households have indeed been working off their debt levels the past few years, but have only reduced those levels by a little more than 3%, from the 2007 highs. With so many Americans still unemployed or underemployed, and with debt levels that constrain purchasing power and also constrain mobility (i.e., the ability to move across country for a new job), it’s no surprise the US housing market remains trapped at levels far below its highs.

Of course, we know how this part goes.

The above chart comes from the February 2012 Economic Report of the President. The above chart (from Chapter 4 of the report) shows that the current bust, in real terms, has seen the worst price decline of all, compared to other historic declines over the past century. Indeed, that there is now little prospect that US residential real estate will ever recapture the old highs says a lot about structural shifts in everything from energy prices to our workforce, that the US faces at least until the end of the decade.

Stealthier Versions of Inflation

But wait a moment. Even if US residential real estate is fated never to be a recipient of inflation, owing to its dependence on oil prices and the automobile-highway complex, is it not the case that Americans have had to endure already a great loss of purchasing power for some time already? The US story of poor wage growth is now marked by some as far back as the 1970s. That is the longer timeline that is often used to explain the transformation from single-earning to double-wage-earning households. Moreover, health care, food, energy, and education costs have seen outsized gains the past 10-15 years.

Considering that most US pension funds, whether by plan or through individual retirement accounts, rely on the stock market, it seems fitting to mark the performance of the SP500 against a basket of commodities. After all, every retiree (and many an institution) eventually converts their financial capital into resources for living. One chart that I like shows the 15-year performance of the SP500 against the most preferred liquid energy in America: gasoline. (chart courtesy of FRED)

While tediously repetitive, the term Middle Class Squeeze still carries weight, as all of the previous components of the problem have only been exacerbated more recently by high energy prices. The purchasing power of the SP500 has literally crashed against oil. What’s particularly handy about the above chart is that when the SP500 was roughly at 1400 near the turn of the millennium, gasoline was indeed (briefly) around $1.00 per gallon. Now, over 12 years later, the SP500 once again trades near 1400, only this time, gasoline sells for 4 times as much, around $4.00 per gallon. But is this inflation?

The loss of purchasing power is certainly a form of inflation. However, what we’ve seen in the past decade is that many of the price changes affecting Western economies have not been driven by tight labor markets, wage inflation, or even reflationary policy -- which the US has engaged for much of the past ten years. Instead, price level changes have emanated most strongly from the universe of natural resources, including everything from copper to oil, and, of course, agriculture. There is no question that cheap money policies from both the US and Japan have been driving speculative bubbles for some time. But housing and stock market inflation, as we have seen, have been transitory.

Structural Changes in Global Price Levels

Inflation has been running fairly hot in developing markets for some time. In regions like Asia, pressured to source food as growing populations bump up against limits to available arable land, the amount of capital devoted to food, shelter, and transportation remains high. However, if we think of lower-earning populations across the globe as a single class, there has been no protection from higher prices offered by developed economies to their poorer populations. The bottom two quintiles of US wage earners struggle with food and energy costs just as much as their counterparts across the globe.

These structural changes in price levels, along with the increasing inability of every population to endure them, have fallen into a statistical gray area. Headline measures of inflation in OECD countries churn out benign readings, while at the same time, poverty grows. But this is a particular kind of poverty, a food and energy poverty, which saps the power of consumers to spend disposable income on an array of other items.

This emerging resource poverty is going to drive further changes in price levels, and in particular it will restrain many forms of consumption, including real estate prices. Cities will find, for example, that with the price level of food rising and real estate prices stagnant with rising transportation costs, urban farming is going to advance very strongly. Note, for example, the resurgence in urban farming in places like Brooklyn, NY, where large tracts of industrial land have lain fallow for decades. Indeed, a classic pattern of 'hot' inflation is that it quickly begins to drive out spending for discretionary goods in favor of true basics, like food.

The Risk We Face

The United States currently enjoys reserve currency status, which enables it to borrow cheaply, and which keeps capital circulating through our government bond markets, which are the largest in the world. Given the backdrop to our post-credit-bubble environment, it is now the consensus view that we will cut a path similar to Japan’s as we oscillate from weak growth back to the stimulative rescue policies of the Federal Reserve.

There is therefore a sense of complacency about an escalation in prices.

First, there are structural changes taking place in the developing world with regards to urbanization and the trajectory of labor markets. Can the supply of cheap labor in the non-OECD continue indefinitely?

Second, populations in the OECD are increasingly trapped in “safe” investments, such as government bonds, which currently restrain interest rates from moving higher. But this also creates a latent vulnerability for if perceptions of safety and loss of purchasing power were to shift hard. This shift in perceptions is ultimately more critical in any step-change to higher inflation than the supposed quantity of “money-printing” that’s been undertaken by global central banks.

Finally, we look at the assets that will benefit, as well as those that will suffer most, should a stronger inflation develop.

Keeping the banks from loaning out the money into a dead economy is important. When the excess reserves fly away hyperinflation will follow. But back to the original point the economy has to suck and people cannot be buying stuff. Lay them off by the millions and the goal is accomplished.

These bankers are evil, they know exactly what they are doing. Its so fricking simple its a wonder how they can keep the public blind so long to their tricks.

Neofeudalism is the new name in the game of people farming. Bankers are attempting to address imbalances created by the Rennaissance and bring back a very old social construct (without any of the previous safety nets).

The government has trillions of $ of worthless promises it cannot honor. These continued involuntary transactions form the capitalized value of total US debt. What is underlying this market is a deflation mega beast looking to extinguish this crap & mode of business and move on with something sound.

Hot inflation is not going to happen with upticks in domestic velocity in our zombie economy. It will happen because the Fed sinks the $ past an acceptible confidence level & foreigners dump it. The Fed's actions to sink may very well be a monetary reaction to an attack by the deflation mega beast.

Also, it's important to remember the fundamental nature of all markets: Collapses are both rare and rapid events.

True (exponential) hyperinflations are often desperate responses to relatively-uncommon collapses. Garden-variety inflation will crawl upwards until something breaks -- and then the exponential phase will begin. But that phase (like a stock market collapse) is relatively rare compared to the daily grind of markets.

This is the same reason that market 'shorts' need to have tremendous patience: Because the nature of markets is to exhibit slow and plodding momentum over the long-term -- punctuated by rare retracements, even-rarer collapses, and multi-generational hyperinflationary/deflationary collapses. To be short the entire market is to be either very patient, or very good at timing.

Asking "Why haven't we seen hyperinflation or deflationary-collapse yet" is a bit like asking where the great California earthquake is. Don't worry: It's coming. But when? Ah... that's a whole other ball of wax.

ZIRP is only indirectly related to inflation. ZIRP allows an overspending government to keep borrowing and overspending. All that borrowed (and spent) money goes right into circulation, causing prices to rise as the currency loses value. When there's a flood of dollars out there from out-of-control government borrowing & spending, people can borrow them at lower interest, which is how ZIRP brings all interest rates down. Basic supply & demand.

But it all starts with a central bank willing to run the presses incessantly. That's whats inflation is, expanding the money supply beyond GDP growth, and the money supply is expanding way beyond GDP, which is actually shrinking, and yes it's gonna get worse because the government is borrowing and spending MORE printed money every year.

If you laid off enough people to counteract all the government spending, the private sector would collapse and nobody would be working. Then you'd have a nation of homeless vagrants and a massive government living totally on printed money. That's when it would all come crashing down.

I still challenge any deflationist out there to cite one single example in history where a currency went to zero, then magically not only bounced back but then allowed you to buy up everything in sight? The end result of hyper-monetary inflation is chaos, destruction and death, not deflation!

But fonestar, haven't you learned by now that history means NOTHING to the deflationary flat-earthers? Why should anyone need to examine history for monetary and financial precedents to the current situation, when they have their ivory-tower Keynesian theories?!

Chronic governmental overspending and exponentially rising governmental indebtedness ALWAYS leads to monetary debasement and/or collapse --- there is not one historical exception to that rule. Yet you still think that "this time is different"?

Sorry, I will place my bet on the hundreds (if not thousands) of clear historical parallels to the current situation ---- all of which saw the savings of the average citizen severely eroded if not destroyed by currency depreciation, and NONE of which were witness to an APPRECIATING fiat currency!

Unpayable debts are UNPAYABLE, period, no matter WHAT particular monetary regime happens to prevail. Default WILL happen to every major national government, one way or another, and such defaults are ALWAYS and inevitably accompanied by currency debasement and/or collapse.

I am shocked that you are willing to so openly declare your complete contempt for several thousand years of monetary history. But if it makes you feel good retreating into your egghead, ivory-tower theories that are divorced from all reality, then have fun doing so (while you can still afford to).

There are literally HUNDREDS of examples of historical parallels to our current fiscal situation --- merely no worldwide ones. But to claim that somehow that one fact makes the present situation qualitatively, instead of just quantitatively, different from all prior such episodes of governmental profligacy is to take not just a giant leap of faith, but an unfounded leap at that.

EVERY prior fiscal and monetary collapse probably had at least one or two elements within it that made it at least slightly different from every other such event --- so what? The essential nature of the situation, and the inevitable political responses to it, are beyond dispute, at least to anyone with even a glimmer of historical knowledge --- you know, that very same history that, like the Marxists as well as like most ignorant Americans, you are willing to casually toss aside and dismiss.

You know, in your ivory-tower hubris, your reliance on theory over fact, your willful ignorance of history, and your implicitly pro-Establishment monetary arguments, you sound remarkably like Ben Bernanke, who similarly likes to darkly warn us about "deflation" even as he continues to debase the US dollar. The fact that you continue to make the EXACT same specious monetary arguments, and errors, that he does only solidifies the comparison.

If you are willing to consider thousands of years of monetary history, and the consistent message it teaches about the inevitable results of governmental overspending and exponentially-rising debt, as 'BS", then our conversation is over --- you are completely closed to rational discussion, as well as in stubborn denial of reality itself.

I still challenge any deflationist out there to cite one single example in history where a currency went to zero, then magically not only bounced back but then allowed you to buy up everything in sight?

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What major currency has gone to zero?

There has never been in history-a time of "world" floating "competing" paper currencies-it's only been since 1975 (chf allowed to float) that we've had this scenario and up until now-we have had inflation-

There is someone who knows their history. My land is alread occupied by people with a vested interest in making sure the land remains productive. This provides some buffering as the politico never likes to have to admit that they are destroying jobs.

"It produces yielkd from upward price movement". First there is no yield whatsoever in Gold except if you lease it.

But there is a appreciation when the Gold reserve as a percentage of monetary base moves up. WHen the Gold reserves just track inflation no gain, when it moves faster than inflation your purcahsing power increases. So a nominal return in Gold is zip nadda, 0. If the nominal return is lower than inflation in basic necessities, you are losing money while in dollar you "gained". This is monetary illusion 101.

You need to be able to measure things without reference to the dollar, so for exmaple is Wheat cheap in corn terms? Is Wheat cheap in Gold terms? Is Silver Cheap in Gold terms? Is Gold cheaper in Yen or USD terms. Is Natural GAs extremely cheap in Yen terms, but not soooo much in Silver terms? The dollar is a fiction at this point.

The CBs and the Morgue want it to look sick. The narrative of the barbarous relic is supported by the incessant manipulation as needed to keep the unwashed out of the gold market. Physical holders are not panicked...and that is what scares the hell out of the TBTFs.

Charts and DMA's have their limitations. If we move into a truly deflationary period you just have to ask yourself what that will do to house prices and therefore bank loan portfolios. If they crash what do you think the value of your cash at bank will be worth in a fractional reserve system.

Whilst gold price may suffer just ask yourself by how much more other assets will suffer and whether cash is king if you cannot get it out of the bank.

These are short term phenomena that cannot continue for too long. In any case if paper assets have underlying real assets, or claims to real assets, how can the paper asset increase while underlying real assets take a tumble?

These are short term phenomena that cannot continue for too long. In any case if paper assets have underlying real assets, or claims to real assets, how can the paper asset increase while underlying real assets take a tumble?

Thanks for telling us about the DMA. WTFC! Did you get that info from YAHOO??? (sarc off). So that we got this straight, the charts are only usefull if the market is NOT manipulated. See this for just alittle bit of light reading: